Market rally lands U.S. stock funds in the money

Investors have reason to cheer but are becoming more selective

RachelKoning Beals

News editor

Every major U.S. stock mutual-fund category enjoyed strong third-quarter gains. But unresolved economic and political concerns are weighing on investors as the year draws to a close.

CHICAGO (MarketWatch) — Talk about a late-summer glow. Wall Street was in a buying mood in the third quarter, and the indexes hit multiyear highs as the days shortened. There was just enough upbeat U.S. economic news to fuel the fire.

To be sure, the market’s flames climbed a high wall of worry, but the major issues — euro-zone inertia; heightened uncertainty surrounding the U.S. election and the danger posed by the “fiscal cliff,” as the prospect of tax-cut expirations and looming federal-spending changes have come to be known; and the Federal Reserve’s latest round of quantitative easing — at least were usual suspects. And, by some bullish accounts, the Fed’s QE3 move in mid-September came at a time when the market rally needed a nod of reassurance.

“Advisers sitting on the sidelines woke up to the fact that the market was actually pretty strong. They got caught up in the headline noise and lost sight of the fact that the S&P 500 is up [more than] 15% this year, and they were missing out,” said Anthony Davidow, a strategist at Guggenheim Investments.

The average U.S. diversified stock fund rose 5.7% in the third quarter, according to preliminary data from investment researcher Morningstar Inc. Indeed, every major U.S. stock mutual-fund category logged strong quarterly gains, with some rising by double-digit percentages. Small caps, precious metals, energy, and other cyclical “risk on” categories stood out, and bunkers like consumer staples held up as well.

“This market doesn’t just have a wall of worry to climb; it has a wall of reality,” said STAAR Financial Advisors’ J. Andre Weisbrod. “There are no quick fixes for the deficit or fiscal problems, but there are pockets of healthy economic activity that are keeping at bay the most dire of bearish conditions.”

Bumpy road

Yet the obstacles Wall Street hurdled in the third quarter still block investors’ path. As the quarter wound down and investors began looking toward the latter part of the year, many fund managers began to take some riskier investments off the table. Fewer and fewer stocks joined the rally, and, at multiyear highs, stocks may see some congestion ahead.

Art Nunes, chief investment officer at Northwest Asset Management, said he unloaded some risk after the run-up from the June lows. Broad indexes, including the Standard & Poor’s 500 Index
SPX, +0.18%
and the Dow Jones Industrial Average
DJIA, +0.37%
are approaching the top of a 12 1/2-year trading range (topping in March 2000 and again in October 2007).

The S&P 500 rose 6.4% in the quarter, including dividends, and has turned in a gain of more than 16% so far this year. Big-picture resistance for the S&P 500, Nunes said, stands at 1,550, about 100 points above the U.S. benchmark’s close on Sept. 28.

“The top end of that range could prove very difficult to get through considering that a long-term secular bear-market cycle can last 19 [or] 20 years, and we’re at 12 1/2,” Nunes said.

Other signs have grabbed his attention. Price-to-earnings ratios are trending down but likely have not bottomed, he said. Meanwhile, P/Es are averaging 22, but typically, at least if following the Shiller 10-year trailing P/E ratio, bottoms emerge in the low teens.

But if the quarter proved anything, it’s that there’s nothing wrong with a little optimism. If housing data is up (and it is), then perhaps the S&P 500 should be, too — a reflection of all the furniture and appliances needed to fill those rooms. Plus, there looked to be some real money behind the quarter’s fund flows, and, although the rally fizzled late, its breadth was encouraging.

Large-cap growth funds rose 6.2% on average in the quarter, topping all broad U.S. stock fund categories, according to Morningstar, and are up 16% so far in 2012, while their blend and value counterparts each gained about 6% in the latest 13-week period.

The upbeat quarter provided the confirmation that some domestic managers needed.

“There is still an overriding positive notion to this market, backstopped by the Fed,” said Michael Turner, senior portfolio manager with Alpha Capital Management, an adviser to the Bearly Bullish Fund
US:BRBLX
which gained 7.8% in the quarter.

Turner said he’s interested in housing and housing-related consumer stocks. He also likes financials (including money-center banks, regional banks and credit-card issuers), whose valuation and scope for earnings improvement, he said, leave them positioned to outpace the broader market for the next couple of years.

The best-performing sector mutual-fund category, meanwhile, was precious metals, up 22.8% in quarter, followed by communications funds, rising 9.9% natural-resources funds, up 9.3%, and energy funds, gaining 8.4%. Dynamic Gold & Precious Metals Fund
US:DWGOX
for example, was the top precious-metals fund, up 27.7% in the period.

Opaque outlook

While European officials and the Fed grab some of the limelight from the November elections, the future of the White House and Congress do matter to portfolios. Election years are always a volatile time for stock investors, especially given the economic softness that won’t end with the voting. Read more: Draghi, ECB give international stock funds a lift.

“Regardless of the outcome [of the election], we expect increased volatility going into the first quarter as the president and Congress wrestle with fiscal responsibilities and avoidance of the fiscal cliff,” said Gene Goldman, director of research at Cetera Financial Group, in a research note.

“In times of rising volatility, we would augment portfolios with positions in alternative investment strategies including exposures to commodities, real estate, long/short equities or mutual funds and ETFs that have these exposures and/or others seeking downside protection. Diversifying exposures to spread assets, such as higher-yielding corporate bonds, also makes sense,” he noted.

As for specific sectors, Republican dominance in Washington could help midcap and regional banks, should these entities benefit from reduced oversight under Dodd-Frank Act, according to the Cetera team. Technology could benefit under either party, although in different ways: Large-cap broadband firms are expected to get a boost from federal spending on the ramp-up of the fiber build-out; presumed reduced tax burdens under GOP rule could encourage the repatriation of overseas tech profits.

And elsewhere? Look for renewable energy to potentially improve under the Democrats. But expect a push for U.S. energy independence, favoring drillers, oil services and “Big Oil” firms, as well as pipeline companies and gas company MLPs to potentially benefit under GOP rule, along with what might be expected to be quick clearance for TransCanada’s Keystone pipeline.

For STAAR’s Weisbrod, who did cut his risk exposure late in the quarter, this uncertainty actually makes U.S. stocks, specifically investment in solid companies, more reassuring than any other assets in a volatile, low-yield investment world. At least for now.

“Monetary policy right now is forcing people to buy equities whether they want to or not,” he said. “The Fed is delaying the inevitable: inflation.”

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